Crowdfunding’s perils, and how to avoid them

Everyone has an opinion on the crowdfunding industry these days: it’s the new thing; it’s over; it’s just getting started, it’s overheated; it’s the future of finance, it’s fundamentally flawed.

The truth is that when it comes to investing in businesses and startups, the critics are partly right: there may be some significant risks for investors. Here’s a look at the types of risks and pitfalls that can most easily ensnare investors and how one could avoid them.

Adverse selection

If you own a promising technology business that needs additional capital to grow, you know where to turn. Even the lay investor knows that Silicon Valley venture capitalists, and those around the country in cities like New York and Boston, are hungry to invest capital into tech startups with a business plan. There are also demo days, incubators, established angel groups, great tech blogs (like this one), and other resources focused on tech companies. So given the extent of this network, it’s exceedingly rare nowadays that the next great undiscovered business just slipped through the cracks.

Because of this, when a technology business ends up on a crowdfunding platform for growth capital, an investor might safely assume that the so-called smart money in Silicon Valley (or elsewhere) have already learned of and passed on the opportunity. This process, dubbed adverse selection, is why crowdfunding investors should be wary of providing capital to businesses in industries that are most often funded by professional investors.

That said, this more efficient funding ecosystem for early-stage capital is not present in all industries. The consumer-products industry is notable in this regard. According to data from the National Venture Capital Association, approximately 50% of the venture capital dollars invested in the first half of 2012 were invested in technology, while just 5% went to consumer products and services. And that is despite the fact that the returns in the consumer space are strong (according to Kauffman Foundation research, the average investor in consumer receives 3.6 times his money in 4.4 years).

Due diligence constraints

For businesses in industries that require heavy technical backgrounds, gaining an understanding of the marketplace and of a particular company’s position within it requires real expertise. Investment firms focused on healthcare often hire industry consultants to determine potential market growth — along with an army of lawyers to check the strength of a company’s intellectual property and regulatory landscape.

Needless to say, individual investors, most of whom are investing as little as $1,000, simply can’t muster anything close to those resources. It makes sense, then, for crowdfunding investors to focus on companies and industries that are more accessible, easier to understand, and on which they can realistically perform due diligence themselves.

“Proof of concept” is also an important concept for investors on a crowdfunding site to understand. Has the company shown that its business model works? Startups are simply more difficult to vet than those that have a historical performance that can be examined. Third-party industry data can help verify performance once a business is operating — a great asset for the average investor, especially if the investor also has familiarity with the product or the market.

Bad investment terms

Venture capitalists and angel investors spend weeks or months negotiating the terms and the structure of a new investment. Crowdfunding investors frankly can’t. Instead, they are typically forced to accept one-size-fits-all terms proposed by the company’s founders or a lead investor. In either case, investors have to be cautious about what terms they’re signing up for; a seemingly savvy investment in a business that realizes tremendous growth isn’t necessarily a home run. I recently saw a pre-launch tech company on a crowdfunding site with a $12 million valuation. Given the company’s early-stage nature, any pro investor would have instantly flagged it as beyond generous to the company’s founders. Remember: There are good companies, and then there are good investments. They don’t have to be the same.

In reality, the primary layer of protection for crowdfunding investors is the caliber of the individuals who are curating the deals in the first place. While individual investors must always assume the primary responsibility for conducting diligence on the terms and the valuation, they should also consider who is screening the deals and whether their backgrounds make them reputable gatekeepers for the platform.

Regulatory issues

Crowdfunding sites that allow you to invest in a company and receive equity, debt or any type of revenue sharing are helping that company issue securities as defined by the SEC. We agree with regulators that these crowdfunding portals should be regulated by a self-regulatory organization (SRO) – likely FINRA. While those rules are written by the SEC, think about this: Would you buy a car made by someone that wasn’t an engineer? Would you go to a lawyer who hadn’t passed the bar? Of course not.

So why would you invest in securities on a site that is run by a management team that had no experience in investing and no demonstrated knowledge of the securities business? Common sense will help lead investors to screen crowdfunding portals for those that have an established background that’s relevant to helping companies issue securities. Just because the crowdfunding site is a tech company doesn’t mean the typical 25-year-old tech entrepreneur is the right one to run it.